Element 4.8: Diversify Your Assets

“It is the part of a wise man to keep himself to-day for to-morrow, and not to venture all his eggs in one basket.”

The two most common financial investments are stocks and bonds. Let us make sure you understand the nature of these two instruments. Stocks represent ownership of corporate businesses. Stock owners are entitled to the fraction of the firm’s future net revenues represented by their ownership shares.⁽¹⁴⁰⁾ If the future net revenues of the business are expanding, the stockholders will gain. The gains of stockholders typically come in the form of either dividends (regular payments to owners) or appreciation in the value of the stock. But there is no assurance the business will be successful and earn income in the future. If unsuccessful, the value of the firm’s stock will decline. While the stockholders are not liable for the debts of the corporation, they may lose all the funds they used to purchase the stock. (Note: “Equity” is another term for stock.)

Bonds provide businesses, governments, and other organizations with a convenient way to borrow money. These organizations acquire funds from bond purchasers in exchange for the promise (and legal obligation) to pay interest and repay the entire principal (amount borrowed) at specified times in the future. As long as the organization issuing the bond is solvent, the bondholder can count on the funds being repaid with interest.

All investments involve risk. The market value of a corporate stock investment can change dramatically in a relatively brief period of time. Even if the nominal return is guaranteed, as is the case of high-quality bonds, changes in interest and/or inflation rates can substantially change the value of the asset. If you have most of your wealth tied up in the ownership of a small number of corporate stocks (or even worse, a single stock), you are especially vulnerable. The experiences of those holding a large share of their assets in the equities of firms such as Blockbuster, Sears, and JCPenney illustrate this point.⁽¹⁴¹⁾

You can reduce your risk through diversification—holding many unrelated assets. Diversification puts the law of large numbers to work for you. While some investments in a diversified portfolio will do poorly, others will do extremely well. The performance of the latter will offset that of the former, and the rate of return will converge toward the average.

For those seeking to build wealth without having to become involved in day-to-day business decision-making, the stock market can provide attractive returns. It has done so historically. During the last two centuries, corporate stocks yielded a real return (real means adjusted for inflation) of approximately 7 percent per year,⁽¹⁴²⁾ compared to a real return of about 3 percent for bonds.

The risk with stocks is that no one can ever be sure what they will be worth at any specified time in the future. Inevitably, there will be periods over which the market value of your investments is falling, only to rise months or years later. But that risk, known as volatility, is a big reason why stocks yield a significantly higher rate of return than saving accounts, money market certificates, and short-term government bonds, all of which guarantee you a given amount in the future. Since most people value the additional certainty that the yields of bonds and savings accounts provide over stocks, the average return on stocks must be higher to attract investors away from their less risky counterparts with more predictable returns.

Mutual funds can help investors diversify and reduce risk. Mutual funds simply combine the funds of a group of investors and channel them into various categories of investments, such as stocks (equities), bonds, real estate, or treasury bills. Thus, there are a variety of mutual fund categories.

An equity mutual fund channels the funds of its investors into the stock of many firms. These funds provide even small investors with an economical way to achieve diversity and reduce risk. The risks of stock market investments are substantially lower if one continually adds to or holds a diverse portfolio of stocks over a lengthy period, say thirty to thirty-five years. Historically, when a diverse set of stocks has been held over a lengthy period, the rate of return has been high and the variation in that return has been relatively low. Regular payments into an equity mutual fund holding a diverse set of stocks provide investors with a low-cost method of investing in the stock market.

Diversification will reduce the volatility of investments in the stock market in two ways. First, when some firms do poorly, others do well. An oil price decline that causes lower profits in the oil industry will tend to boost profits in the airline industry because the cost of airline fuel will decline. When profits in the steel industry fall because steel prices decline, the lower steel prices will tend to boost profits in the automobile industry.

Second, diversification can help protect you against a change in general economic conditions. A recession or an expansion will cause changes in the value of the stocks of almost all firms. But diversification reduces the volatility in the value of your investments because a recession is worse for some firms and industries than others, and a boom is better for some than for others. For example, a recession that harms Max Mara, a high-fashion brand sold worldwide, may boost sales and profits for Zara, a lower-priced competitor. Similarly, recessions may improve the relative position of Skodas compared to BMWs.

Some employers offer retirement programs that will match your purchases of the company stock (but not investments in other firms) or will allow you to purchase the company stock at a substantial discount. Such a plan makes purchasing the stock of your company attractive. If you have substantial confidence in the company, you may want to take advantage of this offer. After a holding period, typically three years, these plans will often permit you to sell the purchased shares and use the proceeds to undertake other investments. As soon as you are permitted to do so, you should choose this option. Failure to do so will mean that you will soon have too many of your investment eggs in the basket of the company for which you work. This places you in a position of double jeopardy: both your employment and the value of your investments depend substantially on the success of your employer. Do not put yourself in this position.

Your job may offer you a general pension fund that is required by the government. These funds can have different investments depending on where you work. It is important to be aware of what your company pension fund is invested in, and to make sure your own personal investments diversify away from the pension fund’s holdings.⁽¹⁴³⁾

We can summarize the importance of stock investments and diversity this way: to achieve their financial potential, individuals must channel their savings into diversified investments that yield attractive returns. In the past, long-term investments in the stock market have yielded high returns. Equity mutual funds make it possible for small investors to hold a diverse portfolio, add to it monthly, and still keep transaction costs low. Investing in a diverse portfolio over a lengthy period reduces the risk of stock ownership to a low level. All investments have some uncertainty, but if the past 150 years are any guide, we can confidently expect that over the long run, a diverse portfolio of corporate stocks will yield a higher real return than will savings accounts, bonds, certificates of deposit, money market funds, and similar financial instruments. Ownership of stock through mutual funds is particularly desirable for young people saving for their retirement years.

Even with bank deposits, which are generally considered of lower risk than stocks or bonds, it is essential to be aware of the risk of bank failure. In the event of a bank becoming insolvent and unable to return your money, most countries offer national deposit insurance that will reimburse you up to a certain limit, which they publicly disclose. If you have more money than the insured limit, it is wise to spread your funds across multiple banks to ensure that the amount in each bank remains below the insured limit. Be cautious if a bank offers an unusually high interest rate on deposits, as this could indicate that savvy investors are steering clear due to potential trouble, leaving the bank desperate for funds. Do not risk your money for slightly higher interest rates! (One notable economist in a post-communist country managed to lose money in three consecutive banks that were offering the "best" rates. Fortunately, he is a theorist, not a finance professor.)

It is also crucial to be vigilant against fraud, especially when presented with investments promising significantly higher returns than the market average (often referred to as "too good to be true"). A stark example was the Albanian Ponzi (or Pyramid) Schemes of 1996. As Albania transitioned from a command to a market economy, many individuals were inexperienced with investments. Criminals exploited this by collecting cash investments, promising returns as high as 5 percent per month or 60 percent per year. Instead of generating profits from legitimate business activities, however, these returns were funded by collecting yet more investments and using that cash to pay earlier investors (hence, the pyramid). As the schemes grew, they became unsustainable, leading to their exposure as fraudulent and resulting in significant financial losses for participants when they collapsed.⁽¹⁴⁴⁾

Similar schemes have emerged in many countries, with notable examples including MMM in Russia during the 1990s. Even investors in seemingly sophisticated financial markets often fall victim to a “for you only” scheme that is too good to be true designed to appeal to their greed. Many Americans fell to the fraud that has proliferated worldwide often referred to as the "Nigerian prince" scam, where someone posing as a wealthy individual or person with access to significant funds. This scam, which initially spread via letters and fax machines in the 1980s and now spreads through social media or email, typically involves receiving a message from an individual claiming to be trapped in a war-torn or politically unstable country. The person promises to reward you handsomely for helping them transfer their money out of the country safely and requests your bank account details to facilitate the transaction. If you provide your account information, the scammer will use it to steal your funds, leaving you with little recourse to recover your losses. There are numerous variations of this scheme; sometimes the scammer will request money to cover fees or expenses, but no payment will ever materialize, and the requests for additional funds will continue indefinitely.

On an even greater level In 2009, when the Southern District of New York charged Bernie Madoff for his $64 billion securities fraud 'Ponzi' scheme, it was one of the most prolific financial crimes in financial history.